September 1984, No. 84-5

Fisher, Thornton and the Analysis of the Inflation Premium

Virtually all references to the Fisher Effect assume that its appearance in nominal interest rates is a simultaneous result of borrower and lender effects. However, Irving Fisher, and Henry Thornton before him emphasized the activist role on the borrower (demand) side of the loan market. Their reasoning is extended here. Borrowers are seen increasing their demands for loans not because they necessarily anticipate inflation, but because the results of inflationary spending first appear on their income statements as higher profits. Ultimately lenders' loan supply schedules shift to the left as they, too, become aware of the decline in real rates. The conclusions reached for the loan market are seen as generalized to all contractual costs in labor and commodity markets.